Financials look ripe, but when to pick?
Smart investing often means buying ‘em when they’re down. And if you’re looking for what’s down this year, the financial services business offers no shortage of pickings.
The global credit crisis rooted in the housing market fiasco has been a nightmare for many banks, brokerages and other financial companies. The industry’s earnings overall have sunk as mortgage defaults have zoomed, and at some firms the bottom line is glowing bright red.
As for the stocks: Citigroup Inc. is off 24% year to date. Brokerage Merrill Lynch & Co. is down 29%. Mortgage giant Countrywide Financial Corp. has plunged a devastating 64%.
By contrast, despite the stock market’s steep sell-off Friday, the Standard & Poor’s 500 index still is up 5.8% this year.
Declines of the magnitude of those in the financial sector typically attract bargain hunters. And that should particularly be true in the case of an industry as important to the global economy as financial services. Nearly all the world is capitalist, and financial companies deal in the raw material that makes it all go: money.
But the question that dogs the financial sector and its investors is whether the worst of the storm has passed -- or whether much more serious credit losses are ahead.
Financial stocks’ fate matters to more than just their holders. The sector is the biggest industry group in the S&P; 500, accounting for about 20% of the index’s market capitalization. (The next largest sector is technology, at 16%; energy is third, at 12%.)
So the market as a whole has a lot riding on the financial industry’s health.
Yet investors’ experience with home builders and mortgage companies this year doesn’t provide much encouragement for the financial sector overall. Almost every month, we’ve heard assurances from some corner of Wall Street that housing was bottoming, or close to it. Now, it’s clear there is no bottom in sight.
This week, U.S. Treasury Secretary Henry M. Paulson Jr. said the continuing slide in the housing market was the “most significant current risk to our economy.”
The lesson from housing is that the industry players didn’t understand how dangerous a bubble they had helped create -- and how severe the fallout would be once it burst.
Maybe that isn’t so surprising. “The contagion effect is underestimated in every single bubble,” said Vadim Zlotnikov, chief equity strategist at investment research firm Sanford C. Bernstein & Co. in New York.
What worries some analysts is the risk that the ranks of troubled consumer and corporate borrowers will burgeon in loan categories beyond home mortgages.
How about car loans? On Friday, an analyst at JPMorgan Securities warned clients in a report that “we are starting to see an increase in prime auto [loan] delinquencies and accelerated repossessions.”
Also on Friday, analyst Andrew Tilton at Goldman, Sachs & Co. raised the specter of a downturn in the commercial real estate market, which has remained robust despite housing’s turmoil.
“Many of the same conditions that drove residential housing activity to unsustainable levels -- easy credit, financial innovation, an influx of new buyers with investment motives -- have contributed to the boom in the nonresidential sector,” Tilton said.
As October began, the conventional wisdom was that major banks and brokerages would take cathartic third-quarter loan write-offs that would effectively clear the decks for an earnings turnaround in 2008.
They have indeed taken big write-offs. The latest to do so was Wachovia Corp., which on Friday said it recorded a $1.3-billion charge-off for certain loans on its books.
But that evidently didn’t make Wachovia investors feel much better about the company’s outlook. Amid a broad market rout, Wachovia shares dropped 3.6%, their sixth straight decline.
Part of the banking titans’ investment story is that they operate in many markets, including consumer banking, investment banking and securities trading. That gives them many ways to make money -- or lose it.
Bank of America Corp. on Thursday disappointed investors by reporting a 32% drop in quarterly profit because of poor results in its investment banking unit, including heavy losses incurred by its securities traders. BofA’s shares slumped 8.6% for the week, to $47.57.
Brian Belski, market-sector strategist at Merrill Lynch in New York, is advising clients to be wary of banks and brokerages in general. “Years of excessive credit creation,” he says, can’t be fixed in a matter of weeks.
There also is the vexing issue of clarity -- or the lack thereof -- in financial firms’ reporting of what’s on their books, or on the books of multibillion-dollar “structured investment vehicles” managed by banks.
It’s fair to say that many bank shareholders probably didn’t know what a structured investment vehicle was until the global credit crunch hit in August and some of these funds suddenly found themselves unable to borrow, leaving their sponsoring banks on the hook.
“You don’t know what’s in [lenders’] portfolios,” said Howard Silverblatt, senior index analyst at Standard & Poor’s. Some investors may question how much the lenders themselves know. One of the big shocks in August was to hear banks and brokerages say they weren’t sure how to value certain mortgage-related securities they owned. That wasn’t exactly a confidence booster.
The great risk facing the financial sector is that credit write-offs will become “a black hole” in 2008, said Tobias Levkovich, U.S. stock strategist at Citigroup Global Markets.
But he said he wasn’t expecting the worst-case scenario. For one thing, the Federal Reserve has begun cutting short-term interest rates, which historically has helped banks by lowering their borrowing costs, Levkovich noted.
What’s more, he said, the resurgence of negative investor sentiment toward financial stocks is “usually a good contrarian indicator.”
Then again, some people thought sentiment was too negative toward home builders’ shares in mid-June, when the average stock was down 19% from year-end. Now the sector is down 54%.
Although major bank stocks have fallen, Zlotnikov said he didn’t believe they were down enough to be attractive given what else could go wrong.
For bargain-hunting investors, however, there’s a crucial difference between home builders and the biggest banks and brokerages: Some builders may just go belly-up, but the bank and brokerage leaders are likely to survive and remain profit machines in the long run because their fortunes are tied to the global economy.
If you’re bullish on world economic growth over the next 10 years, it wouldn’t make sense to be bearish on the biggest firms that supply capital and financial advice to the economy. Innovation in financial services is one of America’s strong suits in the global marketplace.
The only question is how much cheaper the stocks might get in the near term, as the companies pay for the sins of a lending boom that got too creative for the industry’s own good.
